What is a lower limit?
The limit price is the maximum authorized drop in the price of a stock or commodity during a single trading day. Limits were introduced to prevent unusual market volatility and to counter the panic that tends to worsen an initial fall in prices.
- In commodity futures contracts, the limit drop price is the amount by which the price of a contract can fall in one trading day.
- For stocks, the downside limit refers to the maximum drop allowed for individual stocks on certain exchanges before the start of trading.
In both cases, the limit is generally set as a percentage of the market price of the securities, although this is sometimes a dollar amount.
Key points to remember
- In futures trading, the limit price is the percentage of decline possible in one trading day.
- In stocks, the downside limit is the percentage of decline allowed before the automatic trading brakes are triggered.
- The SEC’s Limit Up Limit Down rule is designed to limit the volatility of stock prices created by high frequency trading.
Understanding the lower limit
Some futures markets close the negotiation of contracts when the limit price is reached. Others allow trading to resume if the price goes up from the day’s limit by a preset amount.
If there is a major event affecting the market sentiment towards a particular product, it may take several trading days before the contract price fully reflects this change. Each trading day, the trading limit can be reached before the price of the market equilibrium contract is reached.
This can be a bitter experience for traders who are unable to sell their positions as trading on the stock market is halted as soon as the limit price is reached. A trader may have to suffer several days of losses before recovering enough cash to allow him to completely sell the stocks of commodities.
The infamous 2020 “flash crash” made it clear that the rules of the stock market didn’t keep up with the speed of e-commerce.
This event occurred on May 6, 2020. In a roller coaster ride that only lasted 36 minutes, the Standard & Poor’s 500, the Dow Jones Industrial Average and the Nasdaq Composite all lost value and then recovered just as quickly. The Dow Jones Average alone lost nearly 1,000 points in a matter of minutes.
The May 6, 2020 flash flash showed that stock market rules were not keeping pace with modern electronic trading.
The cause of the flash crash has never been fully explained, although regulators have acknowledged that high frequency electronic communications have at least exacerbated the problem. Other less dramatic accidents have since occurred in other markets, including the commodity markets.
In all cases, the Securities and Exchange Commission has made some regulatory changes, including imposing a so-called Limit Up Limit Down rule. The rule, intended to prevent manipulation or trading error, establishes an upper and lower trading band for each security traded. Trading is suspended for five minutes if the share price moves outside this band.